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Rethinking

Value-Based
Management
n the early 1990s, the business press, securities analysts,

I
ERIC OLSEN and management consultants widely touted value-based
management (VBM) as a new tool to help investors assess
companies and help executives evaluate business perfor-
Value-based mance and shareholder value. And conceptually, VBM was
a great idea. But after a decade of experience both on Wall
management theories Street and inside companies, has VBM realized its promise as
have fallen short in either an investing tool or a management tool?
The answer appears to be mixed. In a recent survey of VBM
practice, especially adopters by professors at INSEAD, respondents’ views ranged
from high impact to little or even negative impact of VBM on
when it comes to their companies. The study’s authors concluded that VBM as a
investor strategy. discipline added value for those companies that adopted it as a
way of life—i.e., a cultural change—and was limited in those that
more narrowly deployed it as yet another management tool.
And recent events raise even broader questions about VBM’s
impact. Where was the influence of the VBM discipline on Wall
Street during the dot-com boom and bust, or in the corporate
suite during the more recent and ongoing controversies over exec-
utive pay and accounting improprieties? Did investors, venture
capitalists, analysts, consultants, boards, and executives fail to
heed the principles, or did the principles of VBM fall short in pro-
viding guidance? And, looking forward, does VBM still offer a
competitive edge or even a relevant management approach for
the next decade?
VBM’s mixed track record suggests that we should reexamine
Eric Olsen is a senior vice president the lessons of the last decade and craft a more comprehensive
and Worldwide Topic Area Leader for and effective approach to deploying VBM. And, in the end, there
Value Management for the Boston really is no alternative but to do so. For many reasons, delivering
Consulting Group. He is based in the superior value creation has become senior management’s most
firm’s Chicago office. For further pressing task. Investors expect it and respond aggressively to its
information, go to www.bcg.com. absence. Management and employee security, opportunity, and

286 HANDBOOK OF BUSINESS STRATEGY


remuneration are more and more closely tied to
stock value performance. Through stock options,
its promise has become a key factor in the attrac- Long-term competitive
tion or retention of both managerial and technical
talent. Most major business publications now put
advantage can be
a spotlight on annual value creation performance dependent on access to
rankings. And—perhaps most importantly—it has
become increasingly obvious in many industries the capital resources that
that long-term competitive advantage is dependent
on access to the capital resources that accompany
accompany superior
superior value creation.
The clear challenge is to rethink how manage-
value creation.
ment can better apply the principles and practices
of VBM to help deliver superior value creation on ic missing links in traditional approaches to
a sustained basis. Here, there are a number of new VBM. Some might observe that these missing
insights and evolving best practice approaches that links are more the province of good general man-
can elevate and extend both the art and the sci- agement than of VBM. But another view is that
ence of managing value creation. These new VBM has much to offer good general manage-
approaches better connect VBM with capital mar- ment beyond economic principles and measures,
kets outcomes and better align organizations to and it loses impact as a respected and enduring
deliver sustained value creation. discipline if it is not fully woven into the overall
fabric of managing long-term value creation.
THREE MISSING LINKS Therefore, it is important that VBM approaches
Traditional VBM approaches did not fully equip be extended to connect these frequently missing
executives with comprehensive perspectives and links. They are:
guidelines for managing value creation. As a result, 1. An incomplete connection with capital mar-
many pursued agendas that either had missing kets realities.
links or disjointed connections with the strategies 2. An incomplete connection with organization
they were pursuing. And VBM’s credibility as an and culture.
overarching management framework suffered 3. An incomplete process for managing the sys-
when executives who bought into the philosophy tem of levers that determine value creation.
found the approach too narrow to address impor- Within each of these categories of missing links,
tant management issues. there are a number of new insights and implied
For example, VBM showed managers how to challenges. For example, a stronger focus on capi-
improve net present value (NPV), but offered little tal market realities reveals the gaps between intrin-
advice about how to achieve a premium valuation sic value and actual stock price. The need to
multiple, or price-earnings ratio (P/E). It defined bridge this gap puts the responsibility for manag-
what the organization should strive for and how to ing a company’s long-term relative P/E (or other
assess decisions or tradeoffs along the way, but valuation multiple) more squarely on business
offered little practical guidance on how to align leaders’ lists of levers to manage proactively. And
the organization and its culture to be more proac- there are a number of new insights and tools avail-
tive and effective at achieving value creation goals. able to quantify and act on the specific drivers of
And, often, VBM practices created unintended relative valuation multiples.
consequences in internal behavior and external Similarly, a stronger emphasis on capital mar-
stock price, because the practices were not kets linkages opens up the opportunity to connect
grounded in a complete systems view and imple- with and manage a company’s investor base more
mentation process that resulted in a consistent effectively. New thinking about investor strategy
and reinforcing value creation agenda. extends the VBM principle of stock market effi-
These shortcomings stem from three pragmat- ciency to recognize that, like one’s potential cus-

HANDBOOK OF BUSINESS STRATEGY 287


tomer base, stock markets are also segmented
around investor groups that have different priori-
ties and that can put different valuations on the Change, not level of ROI
same performance.
During the 1990s many companies stumbled in
on sunk costs, is what
packaging their offerings to investors by assuming matters to investors.
that markets were efficient at recognizing intrinsic
value improvements and investors would readily
migrate to their offering. For example, those in
favor of the Merck-Medco business combination
undoubtedly believed the intrinsic value improve- entire system of influences and levers that deter-
ment logic was obvious, but the different investor mine value creation. Here, traditional VBM
segments that sought out pharmaceutical versus approaches provided rich guidance for managing a
pharmaceutical benefits management companies subsystem of economic principles and levers—but
didn’t agree. Extending VBM’s linkages to capital little on how to further align strategic, cultural,
markets provides important insights for portfolio and behavioral levers. This shortcoming becomes
strategy thinking. even more pronounced when the capital markets
The second missing link, connecting VBM with missing link is added to the equation. Portfolio
organization and culture, gets to the heart of man- strategy and operational priorities need to be
agement practice, and to how VBM can help linked to their impact on P/E, their appeal to the
orchestrate improved value creation. This is per- type of investors who own the stock, and to the
haps the most difficult yet richest long-term vein management practices that determine their effec-
to tap for driving sustained superior value creation. tive delivery. Conversely, investor ownership mix
From empowering and enabling human capital to has implications for portfolio strategy, operational
building superior management capabilities, there priorities, and the design of internal metrics and
are many levers and practices to manage. incentive plans. Value creation results from how
For example, few companies have effectively the entire system of influencers, priorities, and
aligned their planning, budgeting, target setting, levers interact to maximize realized value.
and incentive compensation processes. This failure In short, there is both a wide-ranging challenge
is largely a result of assigning ownership of each and a big opportunity to harness VBM to achieve
process to different functional areas with an improved value creation. Assumptions, priorities,
unclear accountability and/or process for bringing tradeoffs, tools, mind-sets, and culture all need to
them together. The consequences are commonly be reexamined, and at many levels across a compa-
manifested in sandbagged or gamed plans, negoti- ny’s management team.
ated budgets or targets, and incentives that con-
flict with long-term value creation. Or, in a differ- A SYSTEMS APPROACH TO VALUE CREATION
ent vein, many companies have not aligned the A recent observation by a senior executive at a For-
social contract between corporate and business tune 100 company illustrates the core challenge in
unit management in ways that effectively balance developing a value creation agenda: “The easy part
empowerment, intervention, and accountability for of managing value creation is conceptually con-
value creation. The result is often no small dose of vincing managers and employees that it is their
frustration and cynicism on both sides—rather most important, overriding, and shared focus. The
than team spirit around a shared goal of value cre- hard part is figuring out where to start and how all
ation. Here VBM needs to be extended to address of the pieces fit together. Delegation, training, and
the entire range corporate center practices, that is, incentives only take you so far and then they break
to headquarters activities that promote value cre- down into unproductive or misdirected efforts.”
ation across operating units. The system depicted in Figure 1 offers a
The third missing link is lack of grounding in a sequence for thinking about value creation in a
process for thinking about and managing the way that helps crystallize where to start and how

288 HANDBOOK OF BUSINESS STRATEGY


work for discussing the
Figure 1. Value Creation Framework big picture.”
Many companies have
found as much “meat” in
Value Creation Aspirations a high-level dialog around
"Determine what needs to happen" the system as they have in
the accompanying
"Direct Levers"
insights about best prac-
Operational Competitive Portfolio Investor Superior
Strategy for Management, Strategy RTSR
tice in each lever. What’s
Effectiveness Growth Migration been missing in their
planning and manage-
Corporate Center Practices ment dialog processes has
"Determine what actually happens" been a systems view that
ties all of the pieces
together and facilitates
RTSR is relative total shareholder return. It reflects a company's capital gains plus dividend yield the management art of
relative to a peer group or market index. orchestrating value cre-
ation in complex business
organizations.
the pieces need to fit together. The sequence of
thinking begins with establishing an explicit and VALUE CREATION ASPIRATIONS
quantified value creation aspiration. This goal Most executives recognize that it is essential to
defines the stretch challenge that the four direct energize, focus, and align their organizations
levers for driving value must be orchestrated to around a shared mission. When high-level aspira-
meet. These direct levers are shown in the middle tions are clear, compelling, enduring, and rein-
section of Figure 1. The more aggressive the aspi- forced by day-to-day signals, they can have a sig-
ration, the more likely that the company will have nificant impact. But when they are too general,
to manage all all four levers in a reinforcing way. change from year to year, are not supported by
Once management has established the priorities walking the talk, or become diluted by too many
and tradeoffs for managing the direct levers, the supporting goals or qualifiers, they quickly lose
corporate center practices—headquarters activi- their ability to energize and focus an organization
ties—become the indirect lever that needs to be to achieve its potential.
aligned to ensure effective delivery of the intended Many companies could benefit from an aspira-
plan. As the management team thinks through tions “tune-up” which revisits the effectiveness of
each element of the framework, a shared consen- their existing mission, vision, or other aspirations-
sus should emerge about the aspiration, which conveying vehicles. From a value creation perspec-
levers have priority, which levers are strong or tive, our view is that best practice is to establish an
weak elements in the current agenda, and how the overarching, single, long-term aspiration that is
corporate center practices have been aligned to focused on relative total shareholder return
enable the organization to deliver. (RTSR) performance. For many executives, this is
As one CFO recently put it: “I thought this not a new insight conceptually, but in practice
framework was too high level and obvious to gen- most companies do not effectively deploy RTSR as
erate much discussion at our senior management an aspiration-setting tool.
offsite to introduce VBM—in the end we spent For example, many companies have vision or
two hours discussing our priorities, practices, and aspiration statements that focus on achieving mul-
culture in a way that we never had before. It was tiple goals. One Fortune 100 company states its
surprising to see how little consensus and com- aspirations around three key goals:
mon views we had as a management team once 1. Be the leader in markets we serve.
we got beyond individual issues and had a frame- 2. Provide superior TSR for shareholders.

HANDBOOK OF BUSINESS STRATEGY 289


3. Promote the well being of all other stakeholders.
These sound good on paper and provide a great Figure 2. Forward RTSR Calculation
deal of grist for leadership speeches, but they don’t
effectively focus thinking and behavior. Line exec- Anticipated 5-year company cost of equity 10%
utives in this company were frustrated when
strategies to maximize market share failed to meet Anticipated spread to achieve relative TSR goal 6%
short-term financial targets for bonuses, and, con- Forward looking 5-year RTSR target 16%
versely, when proposed acquisitions conflicted
with corporate definitions of markets served. This
latter frustration is similar to what Jack Welch a fair not superior return, and can be thought of as
observed in From the Gut about the potential trap reflecting the expected average TSR for the market
of being #1 or #2 if it leads to defining markets in or a peer group. There are several methods avail-
a way that limits growth. able for estimating the cost of equity, including
In our experience, RTSR can be the most useful capital asset pricing models (CAPM) arbitrage
single way to define and communicate a compa- pricing theory (APT), and dividend discount mod-
ny’s aspirations and the supporting plan for els, but for most companies today, the expected
action—if it is done in the right way. That is, if it is cost of equity is in the 10% range.
grounded in external value realization, explicitly The second calculation requires judgment to
quantified, and then cascaded down into the orga- select the stretch above-average TSR that is
nization as a long-term goal that energizes line aspired to. Here a word or two of caution is in
management and empowers local entrepreneurial order. Achieving superior TSR year in and year out
thinking about all of the levers to achieve it. is a difficult challenge, because it is accomplished
The process of doing so is not arcane, and it only through superior performance improvements
creates targets that are objective, appropriately and not simply by maintaining superior absolute
stretch, and directly link business area manage- levels of performance (i.e., return on equity, ROE;
ment to capital markets discipline. As one senior return on capital employed, ROCE; economic
executive put it: “Translating our RTSR goal into value added, EVA®, etc.). Figure 3 displays two
business unit targets made managers accountable key considerations in selecting a goal for relative
for value creation as if they were CEOs of their TSR spread above average.
own publicly traded companies—and, you can’t The left panel in Figure 3 shows the probability
negotiate performance targets with investors.” of outperforming the S&P 500 average over con-
Whether the RTSR goal was met at the corpo- secutive years. By definition only half of the com-
rate level can be readily measured after the fact by panies will be above median in any given year. For
simply ranking a company’s TSR against its select- those that outperform in one year, the probability
ed peer group’s TSR. Management can also set a that they will outperform again in the next year is
forward-looking target for RTSR and use it to only 25%, and only 12% for outperforming three
assess the impact of corporate and business unit years in a row. In this sense, it’s more difficult to
plans or major strategic initiatives. This requires continue to be the most improved player in the
translating a ranking goal such as top half, top league each year than it is to continue to be voted
third, or top quartile TSR into a specific number— the most valuable player each year. From a value
a number that, if achieved internally, will have a creation perspective, it is more reasonable to set
high probability of resulting in reaching the target- goals for superior achievement cumulatively over
ed ranking for actual external TSR in the future. three, five, or ten years than it is to strive for con-
Figure 2 illustrates the calculations required to tinuous superior performance each year.
develop a forward-looking RTSR target. The right-hand panel in Figure 3 provides
In Figure 2, the first calculation arrives at an benchmarks for the degree of stretch required to
investor’s view of the risk-adjusted average expect- meet a cumulative top quartile TSR goal over dif-
ed return that a company, peer group, or market ferent time periods. On average over the last 20
index is priced to deliver. In this sense it represents years a company needed to deliver a TSR that was

290 HANDBOOK OF BUSINESS STRATEGY


in two different areas.
Figure 3. RTSR Probability and Timeframe One is whether or not to
de-average the overall tar-
get to take into account
business unit or product
Frequency of above median TSR Ratio of top quartile to median TSR (1)
line near-term potential.
60% For example, if the over-
50
50% Over a year 210 % all target is 16%, should
Over 3 years 170% business unit A, which is
40%
Over 5 years 160% competitively disadvan-
30% 25 Over 10 years 140% taged, have a 12% target
20% while business unit B,
12 which has just launched
Note S&P 500 avg.
10% TSR over last 30 years=10% a blockbuster new prod-
0% uct, have a 20% target, or
1 year 2 years 3 years (1) Calculated in rolling periods over the last 20 years for
in a row in a row in a row S&P 500 should all businesses
always have an 16% tar-
get? The best approach
will vary given cultural
210% of the S&P 500 median TSR to be top quar- norms, management philosophy, and diversity of
tile in any given year. This stretch dropped to business characteristics. Most, but not all, of BCG
160% to be top quartile over any given five-year clients that employ this approach have opted for a
period. Thus, if the S&P 500 median TSR in a common target across all businesses or product
given year was 10%, it would have taken a 21% lines as the fairest and most objective way to allo-
TSR that year to make it into the top quartile, cate capital markets requirements to internal busi-
Similarly, if the five-year compound average TSR ness units.
for the S&P 500 was 10%, it would have taken a The second choice is what internal measure the
compound average 16% TSR to be top quartile company will employ to capture a business unit’s
over five years. or product line’s contribution to the RTSR goal.
With no change in a company’s P/E multiple Here, the most effective approach is to use the
and during periods of normal (i.e., 10%) stock total business return (TBR) measure. This mea-
market returns, top-quartile TSR performance sure captures the capital gain and dividend yield
over a five-year period requires an 16% growth in contribution of a business unit or product line in a
EPS, minus a company’s dividend yield. This is simple and transparent formula. Figure 4 shows
actually a heroic accomplishment to deliver consis- one version of the formula, using growth in earn-
tently, considering that the historical average EPS ings before interest, tax, depreciation and amorti-
growth for the S&P 500 is in the range of 6% per zation (EBITDA) as the driver of capital gains. The
year. Aspirations need to be believable and achiev- formula can be readily adapted to use earnings
able to have positive impact on motivation and before interest and taxes (EBIT), net operating
behavior. Many companies would be better suited profit after tax (NOPAT), or operating income for
to set aspirations for long-term RTSR at 2-3% businesses that are not capital-intensive.
points above the market average—after all, most Many companies have found TBR to be a useful
fund managers would be pleased to achieve this capstone measure because it requires business
level of performance for their portfolios cumula- unit management to balance tradeoffs between
tively over the long term. growing EBITDA and managing capital invest-
Once management has set a RTSR aspiration, ments. In order to increase TBR, a business unit
the next task is to cascade it down into the organi- that elects to use cash for investments to improve
zation (business units, geographies, product lines) EBITDA must provide a capital gain that is greater
as a local accountability. Doing so requires choices than the free cash flow “dividend” yield they would

HANDBOOK OF BUSINESS STRATEGY 291


gets are eliminated, sandbagging or gaming of
Figure 4. TBR Formula Example plans and budgets disappear, requests for
resources are more honestly linked to value cre-
TBR = Intrinsic capital gains + Intrinsic dividend yield ation, and local empowerment and accountability
for value creation delivery are increased. And, the
Free cash flow
TBR = % ∆ EBITDA + usefulness of aspirations as a vehicle for driving
EBITDA x multiple
reexamination and stretch thinking about opera-
In practice, most companies use an EBITDA multiple that is derived
tional effectiveness and competitive strategy at the
from the weighted average cost of capital to ensure a correct bal- business unit level is greatly enhanced.
ance between investing cash or returning it to the parent
DIRECT LEVERS FOR VALUE CREATION
have gotten by returning the cash to corporate. Management has four basic levers that they can
And, empirical studies by BCG indicate that the directly activate to meet their RTSR goal: opera-
TBR measure has a much higher correlation to tional effectiveness, competitive strategy, portfolio
actual RTSR than other measures such as EPS management, and investor strategy. These levers
growth, change in EVA, and improvement in ROE. are not independent and must be activated in a
Companies deploying the TBR measure inter- way that aligns them with each other and with
nally send a clear, objective, and empowering mes- value creation.
sage to their business area teams: “You are in Most traditional VBM approaches focus on how
charge of the value creation tradeoffs in your busi- to improve the first three levers and largely ignore
ness as if you were CEOs of your own publicly the investor strategy lever. The intent of traditional
traded companies. You must manage them to approaches was to provide economic principles
deliver a value contribution that is consistent with and supporting measures that helped managers
capital markets expectations for any publicly trad- focus these three levers on value creation. Earn a
ed company—either through increasing value or return above the cost of capital, grow profitably,
by freeing up cash to return to corporate.” and maximize cash flow, not accounting earnings,
This philosophy removes corporate as a buffer were the guiding principles of new value metrics
between business units and capital markets such as cash flow return on investment (CFROI),
accountability, eliminates unproductive negotia- EVA, net present value (NPV), and others. These
tions about targets, and empowers and disciplines principles and measures promised a rational and
business unit management to chart their own common language for assessing business plans,
course for improved value creation. evaluating operating tradeoffs, allocating
In summary, aspirations are an important tool to resources, measuring performance results, reward-
focus, align, and stretch an organization, but they ing managers, and managing the overall portfolio.
must be clear, quantifiable, achievable, locally All in all, it was a compelling array of potential
empowering, and linked directly to capital markets benefits that prompted many companies to adopt
expectations. Grounding aspirations in a RTSR one form of VBM or another. But, while many
goal that is cascaded down to business unit companies achieved a number of these benefits,
accountabilities is the
leading-edge approach for Figure 5. Direct Levers for Value Creation
activating the aspiration
lever. Companies that
have effectively incorpo-
rated this approach into
their planning and incen- Operational + Competitive + Portfolio + Investor RTSR
Effectiveness Strategy Management Strategy
tive compensation
processes experience a
number of benefits:
Negotiations around tar-

292 HANDBOOK OF BUSINESS STRATEGY


many others did not.
And many non-VBM Figure 6. Shortcomings in Traditional VBM Principles
adopters had TSRs that
Traditional Principle Issues Evolved Principle
outperformed industry
Earn a return above the cost Ignores investor Earn a TSR greater than
peers that had adopted a of capital expectations average
formal VBM approach. • Existing assets • Improve your business
Clearly, adopting VBM • Incremental investments more than expected
was not a panacea for Improve intrinsic value Manage both intrinsic value
Ignores drivers of realized
delivering superior value • NPV, EVA valuation multiples and realized value
creation. • Cash, not accounting • NPV must come in a
Traditional VBM prin- package that appeals to
investors
ciples fell short of pro- • Relative multiples are
viding the best guidance driven by management
for value creation largely actions
because they ignored the Stock markets are efficient Ignores investor Treat investors like customers
fourth direct lever— • Investors readily migrate segmentation • Understand the implications
investor strategy. Most of your investor mix
approaches to VBM
focused on delivering improvements to underlying improving can be bad investments. Change, not
intrinsic (theoretical) value and not externally real- level of ROI on sunk costs, is what matters to
ized value. Figure 6 illustrates how a number of investors. Figure 7 shows the relative TSR perfor-
common VBM principles take on different impli- mance of companies in the S&P 500 given their
cations when viewed from an investor’s perspec- starting level of ROI.
tive—and how those principles need to evolve to As shown in Figure 7, companies that had the
provide better guidance for operations, strategy, lowest quartile ROIs on existing assets delivered
and portfolio management activities. RTSRs during the next five-year period that were
“Earn a return above the cost of capital” has on par with those that were originally in the high-
been a core underpinning of all approaches to est quartile of ROI. The implication of this
VBM. But most approaches have viewed this prin- investor-centered logic is that having a high ROI
ciple solely from an internal perspective. The relative to the cost of capital does not equate to a
operational guides most VBM users focus on are superior TSR. To drive value, ROIs must either
getting the ROI on existing assets up to or above improve above expected levels or be accompanied
the cost of capital and ensuring that all incremen- by greater than expected reinvestment growth. And
tal new investments earn returns above the cost of internal targets for ROI improvement or reinvest-
capital. Yet these prescriptions can fall short or ment for growth need to reflect the expectations
even distort the ultimate goal when viewed from that are already in the current stock price. High
an investor’s perspective. For investors, earning a ROI business units can’t coast, and low ROI busi-
return above their cost of capital means achieving ness units are not value eroders per se if they can
a risk-adjusted capital gain or dividend yield that improve ROI above expectations.
is above average (i.e., RTSR >1). Their goal is to In the 1990s many managers were side-tracked
invest in companies that will deliver fundamental by VBM implementations based on the narrow
performance that exceeds the performance expec- conclusion that ROI levels below the cost of capi-
tations already imbedded in the company’s cur- tal were bad and ROI levels above the cost of capi-
rent stock price. They are less concerned with tal were good. This prompted unproductive
whether a company’s ROI on existing assets is debates about sunk cost, acquisition good will,
above the cost of capital than with whether it will allocating shared assets, or calculating the cost of
improve from its current or expected level. Low capital—debates that distracted from the focus on
ROI companies that improve ROI are good invest- improving fundamental performance.
ments while high ROI companies that are not Similarly, the focus on improving intrinsic value

HANDBOOK OF BUSINESS STRATEGY 293


created mind-sets and
priorities that fell short Figure 7. ROI vs. RTSR
of maximizing realized
value creation. An over-
reliance on improving
internal measures such Past 20 Next 1.5
5 year 5 year
as EVA or NPV resulted avg. RTSR
in lack of attention to ROI 15
1.0
managing the company’s
valuation multiple. Most 10
managers believed their 0.5
multiple was not man- 5
ageable or it would take
care of itself (i.e., reflect 0 0.0
1 2 3 4 1 2 3 4
intrinsic value improve- S&P 500 quartile Previous S&P 500 quartile
ment) and focused on
measuring intrinsic
value correctly and then taking actions to improve proposition through a different lens than will value
it. Absolute valuation multiples do, in fact, depend or income investors. In essence, they are like cus-
on macroeconomic and investor sentiment factors tomer segments that look for different features,
that are outside management’s influence. Howev- benefits, and branding. It is difficult to create a
er, relative valuation multiples are largely driven by single package that will appeal to all segments at
factors that are under management’s control. the same time. As a result, each company needs to
Management of risk, transparency of reporting, develop an effective investor strategy that identi-
portfolio mix composition, consistency of results, fies how it can improve value in a way that the tar-
management and meeting of expectations, and the geted investor segments will find attractive over
relative priority among revenue growth, margin the long term. This means that companies need a
improvement, and balance-sheet management at capital markets fact base that includes a careful
the operating level all determine the appeal of a analysis of investor segments that currently own
company’s value proposition to investors. them, and a process for incorporating the owner-
A number of tools are available to isolate and ship mix implications into the other direct levers
quantify the manageable drivers of a company’s that make up a company’s value proposition—
relative valuation multiple. These include investor operational effectiveness priorities, competitive
interviews, benchmarking against a high-multiple strategies for growth, and overall portfolio strategy.
peer, regression analysis of industry multiple dif- Good things to do from an intrinsic value per-
ferentiators, and longer-term market multiple spective may not be the best things to do from a
analyses. But the overriding focus on intrinsic realized value perspective, particularly in the short
value thinking in the 1990s prevented many com- to medium term. Introducing a balance sheet
panies from taking steps to manage their valuation management program driven by EVA will not
multiple. As a consequence many executives were impress the growth investor base of a high P/E
frustrated when their “NPV packages” did not company, and it may even result in erosion of the
impress investors or created investor compromises multiple (realized value) if the program distracts
that undermined their valuation multiple. managers from a top-line revenue growth priority.
In a related, but somewhat different, vein, the Adding a growth leg to a mature business portfolio
principle of stock market efficiency masked the will attract few growth investors and may alienate
requirement and opportunity to proactively existing value investors who prefer that manage-
increase a company’s appeal to investors. While ment focus on improving the core business and
markets are efficient, they are also segmented. use free cash flow to repurchase shares, reduce
Growth investors will look at a company’s NPV debt, or increase dividends. Many moves that

294 HANDBOOK OF BUSINESS STRATEGY


increase intrinsic value measures such as NPV or
EVA may also reduce a company’s valuation multi-
ple. This is because they may dilute the company’s Until senior executives
appeal to its current investor base and, at the same
time, fail to appeal to new investors. know what matters most
In summary, managing the tradeoff between
improving intrinsic value and improving realized
to key investors, their
value is a key challenge that was masked by the strategic moves can
assumptions in traditional VBM approaches. This
tradeoff affects how each of management’s four destroy value rather than
levers should be activated. Adjusting traditional
VBM principles so that they are more investor
create it.
focused is the first step in better maneuvering
those levers for value creation. The follow-up step not a hands-on driver of stock price (i.e., you can’t
is to equip investor-oriented VBM principles with directly pull the P/E lever), they do summarize the
more effective tools for identifying and quantifying health of underlying factors that determine the
opportunities to increase realized value. valuation investors assign to a company’s EPS. As
Here there are two additional tools that can such, the ratio is a reservoir of important insights
help enhance a company’s ability to manage real- that can be acted upon to improve valuation (if
ized value. One focuses on understanding the fun- those insights can be clearly identified). This won’t
damental performance drivers behind relative P/E happen by simply comparing company P/E
or other valuation multiples. The other focuses on ratios—even when artful investment bank or ana-
understanding the investor-oriented drivers of pre- lyst interpretations are applied.
miums or discounts to a company’s valuation. BCG has employed two different analytical
Combined, they provide rich insights about how to approaches to assessing the underlying drivers that
improve realized valuation and what accompany- determine client P/Es (or any other valuation mul-
ing changes to priorities or tradeoffs in operations, tiple such as EBITDA/total value, price/book, or
competitive strategy, portfolio management, or price/revenue multiples). One approach is a paired
financial policies are necessary. comparison of fundamental drivers between two
Quantifying relative P/E drivers. Until the last companies with different valuation multiples. By
decade, P/E multiples were widely used as the pri- comparing the two companies, it is possible to
mary indicators of company valuation. But with identify the factors that would intuitively explain
the advent of value measurement techniques differences in valuation from an investor’s perspec-
emphasizing net present value, EVA, and cash flow tive (e.g., performance volatility, leverage risk, cash
return on investment—and with increasing acade- flow leakage, ROI, portfolio complexity, consisten-
mic and consultancy research showing low corre- cy of strategy). Where there is a direct peer with a
lations between P/E levels and EPS growth—the higher P/E, this approach can pinpoint clear
defensibility of P/E ratios as a management bench- actions that can improve the company’s valuation.
mark came into question. Yet many senior execu- A second approach uses regression analysis to
tives still talk about, worry about, and wonder derive the fundamental factors that explain differ-
about how to improve their P/E ratio, and it is still ences in valuation multiples across a group of
the metric that investment bankers and sell-side companies. The technique, termed relative multi-
analysts emphasize when speaking with corporate ple factor analysis, empirically derives the funda-
executives about their stock market valuation. mental factors that explain differences in valuation
And, when properly interpreted, P/Es (or other val- multiples across a specific sample of companies.
uation benchmark multiples) provide important Sometimes these factors are traditional finan-
information that can help management shape a cial performance variables (e.g., return on net
value creation agenda. assets, return on sales volatility, sales growth, gross
Although P/E ratios are a residual measure and margin, debt to capital). But sometimes they are

HANDBOOK OF BUSINESS STRATEGY 295


more operational factors such as the ratio of self- its core investors did not want. The company’s
service to full-service customers (brokerage indus- institutional investors were dominated by “growth
try). The approach allows testing of a wide range at a reasonable price”(GARP) shareholders. They
of potential valuation differentiators, and results in were looking primarily for stability—consistent,
a formula that quantifies the potential impact of above-average earnings growth but with very low
changing the performance of any given indicator. risk. They were eager to see aggressive reinvest-
Investor strategy premium/discount. Develop- ment to protect and grow the main franchise, but
ing an effective customer-oriented strategy is a not an expensive acquisition and a potentially risky
fundamental pillar of good business practice. But expansion into volatile economies with significant
disciplines such as customer segmentation and exchange rate risks. The company’s plan ran the
product packaging have not been widely applied to risk of alienating its major investors, thereby
a company’s ultimate customers—investors. destroying its P/E multiple rather than saving it.
Like end-use customers of a product or service The goal of investor strategy is to create a prod-
offering, investors differ widely in their apprecia- uct offering that either eliminates discounts to
tion of different combinations of features or bene- underlying intrinsic value or that creates a sustain-
fits. And, as in the case of product/service cus- able valuation premium. Figure 8 outlines the
tomer strategy, companies need to develop an sources of company discounts.
investor strategy that best meets the needs or Obviously, a company’s value will suffer if its
desires of targeted investor segments. strategy is misguided or its operational execution is
Simply offering a future NPV outcome that is poor; these represent failures to capitalize on
high is not enough. Investors care about the pack- intrinsic value improvement opportunities. This
aging of the NPV perhaps more than they care first source of company discounts is a classic focus
about what the bottom line number is. NPV pack- for traditional VBM activities, but is unrelated to
ages that impress or satisfy management may not investor strategy.
connect with current investor or potential investor The remaining three sources of discount are
segments, resulting in a valuation that is a dis- directly related to investor strategy. Each repre-
count to underlying intrinsic value. sents management’s a failure to align the offering
For example, until senior executives know what to investors’ needs and desires. A governance dis-
matters most to their key investors, they can make count occurs when the needs or interests of dif-
strategic moves that destroy value rather than cre- ferent segments of investors are in conflict. It
ate it. That is what nearly happened to one compa- typically arises where there is a mix of dominant
ny with a strong brand franchise and a long history and marginal investors, different classes of
of delivering modest, but profitable, organic shares, or partial listings of subsidiaries. These
growth. Senior executives were concerned about situations are more common than is appreciated.
how the company was
going to meet investors’ Figure 8. Sources of Discount
expectations. They
assumed that sustaining
the company’s unusually
high P/E required that 1
the company grow more 2
3
rapidly. 4
Management was well
down the road toward a
new acquisition and a
Potential Strategy, Current Governance Credibility Compromise Actual
major geographic expan- Value OE Discount Intrinsic Discount Discount Discount Value
sion when it discovered Value
that these big strategic
bets were precisely what

296 HANDBOOK OF BUSINESS STRATEGY


Individuals, management, family trusts, or foun- many firms have discovered, mixing businesses
dations that have significant holdings can have with radically different risk profiles can result in a
very different objectives than institutional discount to their intrinsic risk-adjusted value.
investors. For example, the interests of the Ford Novartis, Monsanto, and others discovered this
Foundation trust can differ not only from those when they mixed high-risk biotechnology business-
of Ford management but also from those of their es with lower risk pharmaceutical businesses.
institutional investors. How well managements Financial theory describes an efficient frontier for
align these diverse interests will determine risk-return tradeoff—it is difficult to occupy differ-
whether institutional investors place a discount ent places on that frontier at the same time and
on the company’s value. maintain an optimal valuation.
A credibility discount occurs when manage- Companies can remove discounts and achieve a
ment’s agenda is either not clear to investors or is modest sustainable premium to underlying intrin-
inconsistently delivered upon. Lack of clarity arises sic value by creating a company brand that either
from either vague or incomplete discussions of reduces investors’ perceptions of risk or increases
strategic intentions, or from ineffective line of their confidence in the stability or extendibility of a
business or strategic milestone reporting that company’s sources of value creation advantage.
leaves key operational performance insights to the Under Jack Welch, GE established such a “brand”
investor’s imagination. Inconsistency erodes credi- that led to a sustained premium over the discount-
bility when management’s statements of strategic ed cash flow valuation of underlying performance.
intent change frequently, when actions don’t But the underlying brand features must be sus-
match stated intent, or when results don’t follow tainable or the premium quickly disappears and
commitments. Credibility with investors can be a can even lead to a “disappointment” discount. Fig-
company’s most important “off balance sheet” ure 9 outlines an investor strategy approach to cre-
asset, if managed effectively. ating a sustainable premium—or at least ensuring
Compromise discounts occur when management the absence of a discount.
offers an overall NPV package that contains trade- If you were to build a powerful product or ser-
offs that are not attractive to investors. Mixing vice brand, you would first assemble a rigorous
businesses having value characteristics with busi- customer fact base and then use that knowledge to
nesses having growth characteristics in the same drive both your product/service development agen-
portfolio is a clear cause of compromise discounts. da and your marketing/advertising agenda to sup-
For example, companies in mature industries port it. The same is true for building a company
that add new growth
businesses to their portfo- Figure 9. Investor Strategy Steps
lios may not be able to
capture the underlying
value of these new busi- Feedback to Tailored communication/
management agenda Fact base development outreach strategy
nesses. Growth investors
prefer “pure play” invest- Acquisitions Who are your investors, Communication
ments that have critical segmented by investment style? content/focus
Diversification
mass around growth What are investors' expectations Targeting New Investors
Growth vs. Return Focus for performance?
opportunities, while Capital Structure LOB Reporting
What is your credibility quotient with
current investors? Strategic Milestone Reporting
value investors prefer Dividend Policy
Share Repurchase How could or should your investor Value Creation Commitment
that management does base change Investor Migration Plan
not dilute near-term Incentive & Target Setting
• To improve valuation?
Planning & Budgeting • In response to strategies?
value realization poten-
tial by making risky or Investor strategy employs the same elements
longer-term growth as marketing strategy to customers
investments with excess
free cash flow. Also, as

HANDBOOK OF BUSINESS STRATEGY 297


brand that creates a pre-
mium price with Figure 10. Example of Multiple Drivers
investors.
As outlined in Figure
9, the process begins 8.9
with a clear understand- +0.5
+0.5
ing of the current +0.5
6.6 +0.8
investor segmentation,

EBITDA Multiple
what their expectations
and needs are, what NPV
features are most attrac-
tive to them, what the
company’s credibility
quotient is, and how the
firm could migrate to
new investor segments to XYZ ROI Use of free Debt to Portfolio Leading
volatility cash flow capital ratio complexity peer
maximize the appeal of
its NPV offering. This
information then feeds back to management’s align corporate center practices—that is, head-
action agenda to orchestrate the content, priority, quarters activities—to ensure delivery. This is a
timing, and consistency of strategic, operational, more important and difficult task than most execu-
and financial policy actions. It also feeds forward tives perceive.
to establish the focus, content, and positioning of Yet the practices of the corporate center are crit-
investor relations communications. ical to sustained superior value creation. When
Many companies trade at a discount to intrinsic they are aligned with value creation, they empow-
value; very few trade at a sustainable premium. An er, enable, discipline, and orchestrate an organiza-
effective investor strategy can eliminate the former tion’s ability to reach its full potential in delivering
and promote the latter. When deep knowledge of value. When they are unaligned or misaligned,
investors is combined with analysis of fundamental they can create barriers or foster counterproduc-
factors that explain valuation multiple differences tive thinking and behavior. And the cumulative
among peers, actionable insights to raise valuation impact of these headquarters activities largely
become clear and high priority. Figure 10 shows determines the pragmatic aspects of company cul-
the results for “XYZ Inc.” ture. Corporate center practices convey beliefs and
Over the last decade, XYZ Inc. had consistently values, establish behavior norms, and signal priori-
experienced a lower EBITDA multiple than the ties. Reinforcing or changing culture to focus on
leading peer in its industry—even though XYZ value creation is largely a matter of how corporate
consistently had a higher ROCE than its peer. center practices are designed and carried out.
Using direct benchmarking and relative multiple More often than not, the combined impact of
factor analysis, XYZ quantified the four primary corporate center practices is neutral to negative in
drivers of the discount that the company’s value- fostering value creation. Often these practices
oriented investors were concerned with. Subse- have not been subject to a comprehensive reexami-
quently, management developed and implemented nation that identifies strong vs. weak practices,
a revised value creation agenda that, within six misalignment across practices, or missing links
months, significantly closed the gap in their rela- within the overall set of practices. Figure 11
tive multiple. depicts the range of corporate center practices that
can either foster or inhibit an organization’s ability
CORPORATE CENTER PRACTICES to deliver sustained superior value creation.
Once management has developed a game plan for There are three steps to developing an aligned
activating the four levers for value creation, it must set of corporate center practices that contribute

298 HANDBOOK OF BUSINESS STRATEGY


porting practices can get.
Figure 11. Corporate Center Practices Several years previously, a
company had realigned
its planning, budgeting,
"Direct Levers"
and incentive processes
Operational + Competitive + Portfolio Investor
to foster greater empow-
+ RTSR erment and accountabili-
Effectiveness Strategy Strategy Strategy
ty for its business unit
management teams.
Management wanted to
Corporate Center Practices
"Determine what actually happens"
increase entrepreneurial-
ism and eliminate unpro-
Balance across goals Role of center style Supporting practices ductive budget negotia-
• Empowerment • Hands-on owner • Leadership & tions. But when the
• Enablement • Hands-off investor guidance
• Discipline • Activist partner • Exploiting linkages program didn’t produce
• Orchestration • Management positive results as fast as
processes
expected, corporate
launched a series of top-
down enablement pro-
optimally to value creation. The first is to reexam- grams—a balanced scorecard tool, a customer
ine the appropriate balance among four different relationship management program, and then an
goals: empowerment, enablement, discipline, and asset productivity program. These programs dis-
orchestration. Is the overarching goal of long- rupted local managements’ focus and priorities,
term value creation better served by fostering a caused them to miss previously established incen-
greater sense of local empowerment, thus making tive targets (requiring reengaging the negotiation
line managers more proactive? Will exploiting process), and resulted in an erosion of corporate
corporate talent, skills, and capabilities through credibility with line managers. The disconnect
direct interventions better enable line managers reached a climax when corporate uncovered a sig-
to improve results? Will a more rigorous disci- nificant opportunity to reduce costs and improve
pline for accountability and for results most new product development by orchestrating a best
enhance value creation? Is it to better orchestrate practices sharing program for manufacturing and
synergies across businesses, to capture between- technology development. None of the business
business opportunities, or to develop common unit leaders would agree to champion the effort or
platforms or capabilities? offer their best people to support it. Cynicism so
It is simply not possible to fully realize all four pervaded the atmosphere between corporate and
goals at the same time. There are tensions business units that driving value creation became
between these goals that make it difficult to give secondary to managing organizational politics.
all of them equal emphasis. For example, Incremental tweaks to corporate center goals
approaches that increase local empowerment tend and practices can result in one step forward and
to reduce enablement and orchestration-and vice one or two steps backward. A more effective
versa. And the priority of these goals will differ, approach is to periodically reexamine all elements
depending on a company’s characteristics (focused in the corporate center and then align them in a
vs. diversified, high growth vs. mature, etc.) and new direction as appropriate. This reexamination
cultural starting point. process begins with assessing the match between
Too often, companies continually tweak their corporate center goals and the existing corporate
corporate center practices to try to achieve the center style. Figure 12 illustrates how different
best of all worlds—and end up with the worst of styles interact with different goals.
all worlds. One recent BCG study revealed how far The three corporate center styles shown on the
out of alignment corporate center goals and sup- left of Figure 12 represent the range of ways in

HANDBOOK OF BUSINESS STRATEGY 299


which corporate can
position its “social con- Figure 12. Corporate Center Style vs. Goals
tract” with line man-
Goal Accountability Orchestration of
agers. One extreme is Style
Line empowerment Results enablement
discipline linkages
the hands-on owner
style, where corporate Low High Medium
High
Hands-on owner “Most decisions “Intervention focused “Paternal
executives control most “Mandate directly”
made at center” on short-term impact” orientation”
of the major decisions
about priorities, trade- High Low High Low
offs, and new initiatives Hands-off investor “Autonomous “Few corporate “Financial, short-term “No intent to
that affect day-to-day fiefdoms” programs” focus” capture synergies”

operating results. Many Medium-High Medium-High


Medium-high Medium-High
companies with a Activist partner “Shared partnership
“Intervene for “Coaching, long-term
“Sell benefit to line
capabilities results, frequent
focused customer set, philosophy” development” reviews” first”
technology base, or com-
mon business model across geographies gravitate established roles and boundaries for both corpo-
toward this style. At the other extreme is the rate executive and line manager behavior. Empow-
hands-off investor style, where corporate has little erment is granted to line managers, but coaching
or no direct influence on day-to-day operating and thought partnering is expected. Enablement is
matters and focuses on disciplining financial done primarily through high-level capability devel-
results and making decisions about managing the opment programs, not specific interventions.
portfolio mix. Many diversified companies adopt Accountability and discipline are promoted
this style. through frequent and open inter-year reviews and
As indicated in the cells of the matrix, the two flexible incentive program design. Orchestration is
styles tend to be polar opposites in their impact on done by corporate taking the time to sell its case
empowerment, enablement, discipline, and for synergies, common platforms, or shared ser-
orchestration goals. As a result, many corporate vices to line executives.
centers are tempted to vacillate between the two Any of the above three styles can work—if it fits
styles to get the best of both worlds. They do this the business characteristics and is adhered to con-
by off and on direct interventions, periodic tweaks sistently. Lack of alignment of practices around
to management processes (e.g., planning, budget- one style or vacillation across styles can diminish
ing, or incentives), and leadership pronounce- the contribution from corporate center activities.
ments. Done carefully, this can work well—for a Once goals and style have been defined, the
while. But more often it eventually results in frus- remaining issue is to clearly align specific corpo-
tration—not a healthy tension—among both cor- rate center practices to support them. Practices for
porate and business unit management. leadership and guidance, exploitation of linkages,
If staying at or moving to either style extreme is and management processes need to reflect the pri-
not appropriate for a company, then the activist ority of goals and the intended corporate style. For
partner style may be the right answer. It represents example, performance metrics used if the goal
a different type of “social contract” than vacillation were maximum empowerment under a hands-off
between hands-on and hands-off styles. And it style would be very different from those used if the
puts a different burden on corporate behavior and goal were maximum discipline under a hands-on
supporting practices. But it is a style that has to be owner style. In the former case, one high-level
constantly worked at to maintain its integrity. Gen- metric (e.g., EVA or TBR) that allowed local trade-
eral Electric is a leading-edge example of how this offs to be optimized would be appropriate. In the
style is applied. latter case, a larger number of focused metrics that
The activist partner style works to create a team limited local degrees of freedom would be appro-
spirit around a shared long-term goal of value cre- priate (e.g., revenue growth, margin, capital turns,
ation based on an enduring respect for clearly free cash flow targets).

300 HANDBOOK OF BUSINESS STRATEGY


REAPING THE BENEFITS
The full benefits of VBM will accrue to those
The cumulative impact companies that best connect VBM practices
of headquarters activities externally with capital markets and internally with
their organizations. Focusing the organization’s
largely determines the efforts around a relative total shareholder return
aspiration that is cascaded down into business
pragmatic aspects of areas is a first step. Managing direct levers for
value creation in a way that recognizes tradeoffs
company culture. between intrinsic value improvement and realized
value improvement is a second. Doing so requires
Similarly, a larger range in annual bonus poten- a focus on the levers that determine relative valu-
tial may be more appropriate for a hands-off style, ation multiples and cause investor discounts. The
and a narrower range of bonus with a higher base third step is to align corporate center practices to
salary may better fit a hands-on owner style. Or a leverage capabilities and the impact of culture on
disciplined and robust long-range business unit value creation.
planning process may better accompany a hands- These steps seem straightforward on paper, but
off style and a more limited business unit annual they have long been overlooked. In fact, it is clear
budget process may better suit a hands-on style. that the last decade’s VBM approaches either did
Few companies have developed a formal process not fully address them or masked the importance
for reexamining and aligning corporate center of tackling them with a fact-based and systems
goals, styles, and practices. Evolution through perspective.
tweaking is the norm. Best practice is to step back We hope the past lessons, new insights, and
periodically (every three to five years, or after a organizing frameworks described here will provide
major acquisition) and charter a task force to com- readers with the ingredients to craft and imple-
prehensively reexamine how effectively the corpo- ment a VBM approach that delivers a successful
rate center is fostering value creation. The task- value creation agenda for next decade. ●
force should start by developing a capabilities and
culture fact base—one that solicits a wide range of
inputs and assembles objective data on capabilities FURTHER READING
and the effectiveness of practices. Mapping this From the Gut, by Jack Welch, Warner Books;
fact base against the current agenda for manage- 2002.
ment’s four direct value creation levers reveals the “Managing for Value: It’s Not Just About the
viability of current corporate center goals, style, Numbers,” by Philippe Haspeslagh, Tomo Noda,
and practices. Then the (often surprisingly obvi- and Fares Boulos, Harvard Business Review, July-
ous) alignment steps can be implemented. August 2001
Company characteristics or the business envi- “Treating Investors Like Customers,” by Gerry
ronment can change significantly over any given Hansell and Eric Olsen, The Boston Consulting
three- to five-year period. Companies need to Group Perspective, June 2002.
manage the evolution of their corporate center “When Vision Undermines Culture,” by Eric
practices in a systematic way to capture untapped Olsen, The Boston Consulting Group Perspective,
opportunities for in value creation. July 1999.

HANDBOOK OF BUSINESS STRATEGY 301